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Monday, 16 December 2019

It was an enlightening and inspiring experience visiting and witnessing success stories of student-led consulting projects in underprivileged communities (villages) in Panama. These projects are facilitated by Global Brigades, an international non-profit that uniquely implements a holistic model to meet a community’s health and economic goals. The projects include establishment of internationally recognized community-owned banks in some of the country’s most under resourced, rural communities, micro-financing ventures created and run by indigenous tribes, helping these ventures succeed by offering hands-on business solutions, and providing healthcare to underprivileged communities.

Tuesday, 18 June 2019

An article by Global Partnership for Education presents an interesting perspective on how education can impact the 17 sustainable development goals (SDG) for 2030 by the United Nations. The following infographic provides a snapshot:

Tuesday, 16 April 2019

A number of organizations have adopted activity based costing to link operating behavior to product and customer segment cost. Overhead costs cannot be easily traced to products. Using a plant-wide predetermined overhead rate is simple, but using such a rate may inaccurately assign costs to products. Activity-based costing is an alternative that attempts to accurately assign overhead costs to products for financial reporting and other purposes. When cost systems were developed in the 1800s, the emphasis was on simplicity because cost and activity data had to be collected by hand and all calculations were done with paper and pencil. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. In the interest of simplicity, companies often established a single overhead pool for an entire factory that used direct labor as the allocation base. Direct labor was the obvious choice because, the information about direct labor was already being recorded, direct labor was a large component of product costs, and managers believed direct labor and overhead costs were highly correlated.

However, conditions changes necessitating a change in the evaluation of costs. Most companies now sell a large variety of products that consume differing amounts of overhead. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. These changes suggest that a plant-wide overhead allocation system may not be optimal for many companies in today’s business environment. Many companies use departmental overhead rates, instead of a plant-wide overhead rate. The nature of the work performed in a department will determine the department’s allocation base. For example, the overhead costs in a machining department may be allocated using machine hours. On the other hand, the overhead costs in an assembly department may be allocated using direct labor hours.

Departmental overhead rates, however, will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. This is because the departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production. A more sophisticated approach, such as activity-based costing, is required to account for these other factors.

Activity based costing (ABC) uses numerous allocation bases in an attempt to assign overhead costs more accurately to products than the plant-wide or departmental approaches discussed thus far. The basic idea of ABC is as follows: A customer order triggers a number of activities --> Performing the activities consumes resources --> The consumption of resources incurs costs. An activity in activity-based costing is an event that causes the consumption of overhead resources. An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity are accumulated. An activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume. An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.

In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources. Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.

A common framework for combining activities in manufacturing companies is as follows:

Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.

Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.

Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities.

Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities.

Using activity based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the following six activity cost pools:

Labor related pool

Machine related pool

Setup pool

Production order pool

Parts administration pool

General factory pool

In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.

The complexity has increased the need for providing information about the package and has increased downstream activities.

To address this issue, UPS system is based on traditional ABC in that it takes detailed functional cost and maps it to products based on the activities that the products drive.

UPS’s ABC System leverages their database of work measurement and package movement detail to improve our understanding of activity cost drivers. Work measurement studies have been performed on work activity at UPS as far back as 1921. These studies provide important insights into the content of activities and the rate at which products drive these activities.

UPS maintains detailed package flow control systems. The information regarding how products move through UPS system provides important cost insights. Additionally, ready access to this data allows for frequent re-calibration of their models.

UPS has a highly efficient network of shared assets that constantly adjusts to meet demand. Resources are shared across product lines making it difficult to identify unique cost differences. Analysis of UPS package flow models provides a framework to begin to answer such questions as:

What activities were needed to get the package to the final destination?

What information system resources were required?

What share of the activities and resources did the package consume?

What did these activities and resources cost?

The ABC system supports several applications:

1) Performance Measurement: Provides a view of cost and profitability of a division by product across the network.

UPS costing methodologies allow for the creation of P&L views across multiple dimensions:

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Activity and Customer analysis help in determining the most efficient way to minimize cost for both UPS and the customer. It helps in:

Focusing operational improvement efforts on high impact areas.

Changing shipping behavior to minimize cost impact on UPS’s network.

Modifying distribution network to reduce total transportation cost.

Integrating logistic solutions to help optimize benefits across the entire value change.

UPS uses data mining techniques to analyze over 50 million records so that profits can be associated to all packages and customers. Customer level profitability gives insights into trends affecting their customer portfolio. Data mining techniques such as Classification and Regression Trees (CART), Chi-square Automatic Interaction Detector (CHAID), Self Organizing Maps, etc. are used to identify meaningful customer groupings. Monitoring customer accounts has enhanced their ability to understand effects of various strategic initiatives.

UPS has extended their Activity Based Costing techniques to measure invested capital. Invested capital is assigned to products based on unique usage of each asset type. Results reflect widely varying degrees of capital intensity across ground and air operations. UPS includes capital requirements into pricing and growth strategies to ensure positive economic profit.

Wednesday, 13 March 2019

Two costing systems are commonly used in manufacturing and many service companies – process costing and job-order costing. A process cost system is best used by companies that produce many units of a single product and when one unit of output is indistinguishable from any other unit of output. Because the units of output are identical, the company will probably use an average cost system to determine product cost. A company would use a job-order costing system when many different products are produced in each period. The products are usually manufactured to customers’specifications. The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job. With job-order costing, many jobs are worked on during the period; with process costing, a single product is produced for a long period of time. With job-order costing, costs are accumulated by individual jobs; with process costing, costs are accumulated by departments. With job-order costing, average unit costs are computed by job; with process costing, average unit costs are computed for a particular operation or by department.

In a job-order costing system, direct materials and direct labor are both assigned to individual jobs on which the materials were used and the labor incurred. Manufacturing overhead includes indirect materials and indirect labor as well as other manufacturing costs, like the power used to run the machinery in the factory. Manufacturing overhead cannot be traced directly to specific jobs; rather, it is allocated to jobs on the basis of a predetermined rate. Overhead is applied to each job that’s in process using the predetermined rate.

The accounting department relies upon a job cost sheet for tracking the direct and indirect costs associated with a given job. In a job cost sheet, a job number uniquely identifies each job. Direct material, direct labor, and manufacturing overhead costs are accumulated for each job. And, the job cost sheet is a subsidiary ledger to the Work in Process account.

Once a sales order has been received and a production order issued, the Production Department prepares a materials requisition form to specify the type, quantity, and total cost of materials to be drawn from the storeroom, and the job number to which the cost of the materials is to be charged. For an existing product, the production department can refer to a bill of materials to determine the type and quantity of each item of materials needed to complete a unit of product. The Accounting Department records the total direct material cost on the appropriate job cost sheet. The material requisition number is included on the job cost sheet to provide easy access to the source document.

Workers use time tickets to record the amount of time that they spent on each job and the total cost assigned to each job. The Accounting Department records the labor costs from the time tickets (e.g., $88) on to the job cost sheet.

Manufacturing overhead is applied to all jobs that are in process. Firms apply overhead using a base which they believe causes overhead costs to be incurred. Some companies allocate manufacturing overhead using direct labor hours, direct labor dollars, or machine hours. Overhead costs must be allocated to jobs for a variety of reasons. First, it is difficult, if not impossible, to actually trace overhead costs to a particular job. The cost of grease for machinery to manufacture our product is part of manufacturing costs. It would be impossible to accurately trace the amount of grease consumed to manufacture one unit of output. Manufacturing overhead also includes a number of different costs and it would be very difficult to gather all of them together in time to charge them to a particular job. A job may be complete and sold before we can determine the actual overhead costs incurred. Finally, many types of overhead are fixed in nature even though output fluctuates during the period.

To facilitate the allocation of manufacturing overhead to each job, organizations calculate a predetermined overhead rate before the period begins. The rate is calculated by dividing the total estimated amount of manufacturing overhead for the coming period by the estimated quantity of the allocation base for the coming period. For example, if allocation base is machine hours, a firm would estimate the total number of machine hours used in production in the coming period. Ideally, the allocation base should be a cost driver, that is, it causes overhead to be incurred. Predetermined overhead rates that rely on estimated data are often used because actual overhead costs for the period are not known until sometime after the end of the period; thereby inhibiting the ability to estimate job costs during the period. Actual overhead costs can fluctuate seasonally, thus misleading decision makers. Therefore, using a predetermined overhead rate simplifies record keeping.

Manufacturing overhead is applied to jobs using the predetermined overhead rate multiplied by the actual amount of the allocation base used completing the job (this is called a normal costing system).

A T-account approach to looking at the cost flows in a job-order cost system is as follows.

When raw materials are purchased, they are debited to the raw materials inventory account and credited to accounts payable. The cost of direct material requisitions is debited to Work in Process and added to the job cost sheet, which serves as a subsidiary ledger. The manufacturing overhead account is debited and the raw materials inventory is credited for the indirect materials used.

As shown below, wages and salaries are initially recorded in a payable account. Direct labor is charged to work in process inventory through the Job-Cost Sheet. Indirect labor is charged to manufacturing overhead.

Other actual manufacturing overhead costs are debited to Manufacturing Overhead. The credit side of the entry is the various liability accounts (e.g., Accounts Payable and Property Taxes Payable), prepaid asset accounts (e.g., Prepaid Insurance) and contra-asset accounts (e.g., Accumulated Depreciation).

Next, as shown below, manufacturing overhead is applied to each job in work in process inventory by debiting Work in Process and crediting Manufacturing Overhead for the amount of applied overhead based on the predetermined overhead rate. Actual manufacturing overhead costs are not debited to Work in Process, nor are they charged to jobs via the job cost sheets.The Manufacturing Overhead account is a clearing account. The actual amount of overhead incurred during the period (debit side of the account) will not be equal to the amount applied to the Work in Process account (credit side of the account). Any variance between actual and applied will be accounted for as a year-end adjusting entry.

Companies that use job-order cost systems to assign manufacturing costs to products also incur nonmanufacturing costs. Nonmanufacturing costs should not go into the Manufacturing Overhead account. Nonmanufacturing costs are not assigned to individual jobs, rather, they are expensed in the period incurred. For example, the salary expense for employees that work in a selling or administrative capacity are expensed in the period incurred. And, advertising expenses are expensed in the period incurred. This journal entry illustrates the expensing of nonmanufacturing costs in the current period.

The sum of all amounts transferred from work in process to finished goods represents the cost of goods manufactured for the period. As shown below, the Work in Process account is credited and the Finished Goods account is debited.

As shown in the following figure, when a finished job is sold to the customer, the cost of that job is transferred from Finished Goods inventory to Cost of Good Sold. Cost of Goods Sold is an income statement account. If only a portion of the units associated with a particular job are shipped, then the unit cost figure from the job cost sheet is used to determine the amount of the journal entry.

Assuming the company uses a perpetual inventory system, two journal entries are required to record the sale. The first entry is to debit either Accounts Receivable or Cash and credit Sales for the selling price of the job completed. The second entry is to debit Cost of Goods Sold and credit Finished Goods inventory for the cost incurred to complete the job. The difference between the selling price and cost is the company’s gross margin on the job.

There are two complications relating to overhead application: defining and computing underapplied and overapplied overhead. When we apply overhead on the basis of a predetermined overhead rate, there is always the chance that the amount of overhead applied will be different from the amount of overhead actually incurred during the period. When there is a difference, we refer to the amount as either underappliedoverhead or overappliedoverhead. Underapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is less than the total amount of overhead actually incurred during the period. Overapplied overhead exists when the amount of overhead applied to jobs during the period using the predetermined overhead rate is greater than the total amount of overhead actually incurred during the period. As shown below, the simplest way to account for any remaining balance in the Manufacturing Overhead account is to close it out to Cost of Goods Sold.

In larger companies, multiple predetermined overhead rates are often used. For example, each production department may have its own predetermined overhead rate. Using multiple predetermined overhead rates is more complex. When a company uses multiple rates, it promotes greater accuracy in the allocation process because it provides recognition to differences across departments in how overhead costs are incurred.

Thursday, 28 February 2019

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Tuesday, 19 February 2019

Awareness of some fundamental cost concepts enable operations and supply chain managers to deliver higher value to their organizations. However, in most cases there seem to be a lack of understanding (and interest) in these concepts. In this post I present some information that would hopefully help in bridging the knowledge gap.

Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product. Direct materials are raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, the blank video cassette in a pre-recorded video, and a radio in an automobile. Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor”since it consists of the costs of workers who “touch”the product as it is being made. Manufacturing overhead includes all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden). Manufacturing overhead includes indirect materials that are part of the finished product, but that cannot be easily traced to it and indirect labor costs that cannot be physically or conveniently traced to the creation of products. Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, and salaries for supervisors, janitors, and security guards.

A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes, most of these other costs are typically classified as selling costs and administrative costs. These costs are also called selling, general and administrative costs, or SG&A. Selling and administrative costs are incurred in both manufacturing and merchandising firms. Selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs. Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization that are not classified as production or marketing costs.

Costs can also be classified as product or period costs. Product costs include all the costs that are involved in acquiring or making a product. In the case of manufactured goods, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle, product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. According to the usual interpretation of Generally Accepted Accounting Principles (GAAP), all manufacturing costs are treated as product costs. Period costs include all selling and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees.

The flow of costs in a manufacturing company can be represented as follows:

Raw materials are purchased and placed into raw materials inventory. Next, raw materials are requisitioned out of raw materials inventory into work in process. Direct labor and manufacturing overhead are charged directly to work in process inventory. When a firm completes the product, the product and its costs are transferred out of work in process inventory into finished goods. All raw materials, work in process and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet. As finished goods are sold, their costs are transferred to cost of goods sold on the income statement. Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported in the income statement for the period the cost is incurred.

Within the income statement, merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minusEnding Merchandise Inventory. However, for manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. They calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minusEnding Finished Goods Inventory. For a manufacturing company, some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as an asset. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold.

Cost changes in response to changes in activities:

Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity, internal to the company, such as the number of purchase orders processed during a period. Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs. The total of just about any cost will change if there is a big enough change in activity. It is therefore important to consider the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. Whereas others refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. The latter definition highlights the notion that fixed costs can change if the level of activity changes enough.

A variable cost varies in direct proportion to changes in the level of activity. Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. A fixed cost is constant within the relevant range. In other words, fixed costs do not change for changes in activity that fall within the “relevant range.” When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost decreases when activity rises and increases when activity falls.

A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects, costs are classified two ways:

Direct costs are costs that can be easily and conveniently traced to a unit of product or other cost object. Examples of direct costs are direct material and direct labor.

Indirect costs are costs that cannot be easily and conveniently traced to a unit of product or other cost object. An example of an indirect cost is manufacturing overhead. Common costs are indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.

It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant to the decision. All other costs and benefits are irrelevant and can and should be ignored. To make decisions, it is essential to have a grasp on three concepts: Differential costs, opportunity cost, and sunk cost.

Differential costs (or incremental costs) is a difference in cost between any two alternatives. A difference in revenue between two alternatives is called differential revenue. Differential costs can be either fixed or variable.

An opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed, they cannot be differential costs; therefore, sunk costs should be ignored in decision making.